Kalpen Parekh, President, DSP Investment Managers, explains how various types of behavioral biases can cost investors dearly in their financial journey, during an interview with Himali Patel. Edited excerpts.
• What are the common errors investors make while choosing an investment option?
We like the comfort of past returns and invest if returns are high, irrespective of the asset class. All asset classes have high and low points and their returns often fluctuate. If we invest only when past returns are high, especially in stocks and gold, it also means we are buying at high prices. Hence, before the cycle turns down, returns fall.
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Secondly, we give too little time for our money to grow and multiply. We invest for short periods. Lastly, unlike Fixed Deposit (FDs) or real estate, we watch prices daily for mutual funds and stocks, just because they are available and react against our interest.
• What are the behavioral biases investors make?
We are all subject to multiple biases in any aspect of life and investing is no different. The list of biases is too numerous to talk about here, but I’ll mention some of the most common ones. Recency is one such bias, where investors are inclined to favour buying financial instruments that have performed well. This is not necessarily what they understand. This is also true of investing in the broader markets as it is observed that the bulk of investors get into the markets after it has run up significantly and not much of the upside is available.
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The ensuing fall in these instruments or the markets makes investors pay for this bias. Another similar bias is pursuing past returns, where many prefer investing in stocks or funds that have performed well in the past, expecting a similar level of performance in the future as well. Confirmation is another common bias that is prevalent in this era of information overload. Investors may consciously build a view and only selectively choose those data points that are in agreement with their views. Needless to say, these biases can cost investors dearly in their financial journey.
• How does elimination strategy work while choosing a more decisive base investment planning, when it comes to mutual funds and direct stocks?
A famous quote by Charlie Munger goes - “All I want to know is where I will die, so that I may never go there’. Hence, avoiding mistakes can be a key component in one’s investment strategy, as to make up for a fall in the portfolio requires a larger degree of returns. The key aspect of an elimination strategy is the principle of not losing first.
The emphasis can be on companies that are governed well, have a favorable market positioning and profitability metrics, which can eliminate potential value destroyers. The advantage of this is that the chances of outperforming are better when you remove stocks that are not consistent in certain metrics. This also acts as a shield, especially during volatile times. This is also similar to Michelangelo an Italian sculptor removing the unwanted part of the rock to make the beautiful masterpiece he made. All he did was to eliminate first.
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• How could investors get ready for the changing market cycle?
Investors should keep in mind that fluctuations are natural for the markets and their returns would also vary in the short and medium-term. We are in an environment where interest rates are at an all-time low, while good companies and alternate assets are near their all-time highs.
This poses a dilemma of not knowing where to invest. It is probably not a good idea to be an all-in-one asset class or aim for finding the next long-term play. This is the time to avoid value destroyers, prudence and sensible asset allocation spread across equity, fixed income, global funds, and alternative asset classes. Another aspect is to manage returns expectations from the equity in the era of low-interest rates.
